One of the biggest changes when making the transition to retirement is giving up the steady paycheck from your employer. In retirement, the responsibility of replicating this paycheck shifts to you, but it can be difficult to understand how to use your investments and income sources (like Social Security) to create your retirement paycheck. In this episode, we explain the entire process, including understanding what will make up your paycheck, how to create it, checking whether your investment withdrawal rate is “safe,” and being smart with tax planning and strategically withdrawing from your accounts in order to minimize the amount that goes to the IRS.
Outline of this episode
- Getting organized [1:44]
- Understanding what makes up your retirement paycheck [3:35]
- Creating a portfolio that is made for retirement withdrawals [5:48]
- Sustainable withdrawals using the 4% rule [8:44]
- Three tax buckets to be aware of [13:10]
- The 5 steps to creating your retirement paycheck [22:59]
Creating your retirement paycheck in 5 manageable steps
Step one, get organized. You’ll need to understand your rough annual spending, your income sources (like Social Security), and the total of your various investment accounts. Step two, understand what makes up your retirement paycheck, which is a combination of your income sources and withdrawals from your investment accounts. Step three, once you know how much is required to withdraw from your investment accounts, you want to make sure the amount you’re taking out is sustainable throughout your retirement. You can use the 4% rule as a starting point for this. Step four is to be aware of the different tax treatments for your accounts. Roth IRA accounts are never taxed again but with traditional, or pre-tax, IRAs you pay tax on every dollar you take from your accounts. And finally, with taxable accounts, you get the preferential capital gains tax treatment and are only responsible for paying taxes on the gains. And finally, step five is to create an overall retirement tax plan of how to withdraw from your various investment accounts and implement strategies like Roth IRA conversions to focus on lowering your lifetime tax bill.
Breaking down retirement income to determine your paycheck
As people get closer to retirement, most of the time they are aware of the different account balances they have, along with a rough idea of what Social Security will be. But then it’s hard to understand if A) this combination is enough to retire and sustain them throughout retirement and B) logistically how these different pieces will actually fund their retirement. In this episode, we use an example of spending $120,000 per year with $60,000 of Social Security and $2 million of investment assets. Join us as we break it down into what it means for creating your retirement paycheck.
Three tax buckets to be aware of for strategic withdrawal planning
The first bucket is Roth money. This bucket is after-tax money, which you may have from making backdoor Roth IRA contributions during your working years. What’s great about this bucket is that the money and the growth will never be taxed again in the future.
The second bucket is traditional or pre-tax money, this bucket likely includes your 401k, 403b, 457b, or traditional IRAs and rollover IRAs. It’s likely your biggest bucket because these accounts are where you received a tax deduction when you made the contributions during your peak earning years.
The last bucket is taxable accounts. These are accounts like an individual or joint account, also known as a brokerage account, that you invested any money above what you put into your retirement buckets. These accounts offer preferential capital gains tax treatment based on the increase in value since you invested the money. For example, if you invested a $100k and now it’s worth $105k, you only have to pay taxes on the $5k of gains when using the $105k to fund your retirement paycheck.
Since these three different buckets all have different tax treatment, it allows you to develop an intentional and strategic plan on how to withdraw from the accounts in order to minimize your lifetime tax bill as you work toward funding that retirement paycheck.
Resources & People Mentioned
- Download our guide: How to Create a Paycheck in Retirement